What Is Financial Due Diligence?
Financial due diligence (FDD) is an independent investigation of a target company’s financial affairs conducted on behalf of a prospective acquirer, investor, or lender. The objective is to verify that financial information is accurate, identify risks and liabilities that may affect the transaction price, and provide a basis for post-acquisition integration planning.
Scope of a Typical FDD Engagement
- Quality of Earnings (QoE): Normalising EBITDA to remove non-recurring items and identify the maintainable earnings base for valuation
- Working Capital Analysis: Establishing a normalised working capital peg and understanding seasonal fluctuations
- Net Debt and Net Debt-Like Items: Identifying all debt obligations, contingent liabilities, and off-balance-sheet exposures
- Tax Due Diligence: Reviewing tax compliance history, outstanding assessments, and transfer pricing exposures
- Cash Flow Analysis: Assessing the cash conversion cycle, capex requirements, and free cash flow generation
Red Flags in SME Acquisitions
- Revenue inflated by related-party transactions at non-arm’s-length prices
- Director loans not properly documented
- Unrecorded contingent liabilities (litigation, tax assessments, lease dilapidations)
- Inventory overstatement due to obsolescence
- Aggressive revenue recognition
- Undisclosed MPF arrears
Case Study: Retail Chain Acquisition
A private equity firm considering a Hong Kong specialty retail chain acquisition engaged Aaron Wong & Co. for financial and tax due diligence. The vendor presented EBITDA of HK$8.2 million. FDD identified normalisation adjustments totalling HK$2.4 million, restating EBITDA to HK$5.8 million — a 29% reduction that materially affected the acquisition multiple. A tax review also identified a pending IRD assessment of HK$1.4 million, for which a specific indemnity was negotiated in the sale and purchase agreement.